Chapter - 3

International operations and international investment appraisal

 Introduction

This chapter first introduces the concepts of

international trade and multinational companies, and
then looks at the additional complexities when making
investment decisions in an international context.
 Multinational companies (MNC)

A multinational company (MNC) is defined as one

which generates at least 25% of its sales from
countries other than its own.
Reasons for overseas trade

Economies of Scale

Specialization

Competition

Choice
Trade barriers Quotas
Embargos

Tariffs

Exchange Administrative
Controls Controls
International Financial Institutions
The most important of these are:

• World Trade Organisation (WTO)

• International Monetary Fund (IMF)

• International Bank for Reconstruction and

Development (IBRD) – more popularly known as
the World Bank
The World Trade Organisation (WTO)

 Main aims are to

reduce the barriers to
international trade.

 Mediator for trade

disputes between
countries.
 Protectionist measures

Advantages of reducing Disadvantages of

protectionist measures reducing protectionist
• Better relationship with measures
other countries (Gain • Adversely effect
political capital) domestic supplier
• Increased trade and • Might increase
economic growth ‘Dumping of goods’
• Technology transfer
 International Monetary Fund (IMF)

• Promoting international
financial cooperation
• Establishing a system of
stable exchange rates
and freely convertible
currencies
• Providing a source of
credit for members
World Bank - International Bank for Reconstruction
and Development (IBRD)
The original purpose of
the IBRD was to help
finance the
reconstruction of
economies damaged by
the war. However, it soon
shifted the focus of its
lending to countries of
the developing world.
 Trade agreements

Policies adopted by governments to encourage free trade include:

 Bi-lateral trade agreements
 Multi-lateral trade agreements
 Economic unions (Eurozone).
Strategic issues for multinational organisations

 Implications of an increased mobility of capital

 Political risk
 Economic risk
 Transfer pricing
 Goal incongruence (Control and agency issues )
 Foreign investment appraisal

Step 1 – Estimate the project’s cash flows post-tax in

the overseas currency

Step 2 – Convert CFs to the home currency

Step 3 – Add any additional home country CFs

Step 4 – Discount Net CF using Cost of capital

applicable in home country
 Important Adjustments

 Forecasting foreign exchange rates

 Double taxation
 Inter company cash flows
Remittance restrictions
 Forecasting foreign exchange rates

Purchase Power Parity Theory

Purchasing power parity (PPP) theory states that
the spot rates between two currencies will change
over time in relation to the rate of inflation in the
countries from which the currencies originate.
PPPT is based on: 'the law of one price’.
In equilibrium, identical goods must cost the same,
regardless of the currency in which they are sold.
The current exchange rate for the British pound and the US dollar is £1 = $2. It is
expected that the rate of inflation in the UK will be 3% per year for the next few
years, and in the US the rate of inflation will be 2% per year.
 Forecasting foreign exchange rates
Interest rate parity theory
Interest rate parity theory states that
changes in an exchange rate are
caused by differences in interest
rates between two currencies.
 Cross rates
Example
A Greek company has to pay $100,000. So need to know euro/dollar exchange
rate.
Available in question:

Calculate the value of the payments in euros.

Parrott Co is a UK based company. It is considering a 3 year project in Farland. The project will
require an initial investment of 81 m Farland Florins (FFl) and will have a NIL residual value.
The project's pre-tax net FFl inflows are expected to be:

The UK parent company will charge the overseas project with £2m of management charges
each year. The current spot rate is 5FFl – £1. UK inflation is expected to be 4% per annum, and
Farland inflation is expected to be 7% per annum.
Farland tax is 20% and is paid immediately. Any losses are carried forward and netted off the
first available profits for tax purposes. Tax allowable depreciation will be granted on a straight
line basis. UK tax is 30% and is payable 1 year in arrears.
Parrott Co recently undertook a similar risk project in the UK and used 11% as a suitable
discount rate.
Required: Calculate the NPV of the project in £.